I’m a Professor of Economics at University College, Dublin. I have a PhD in economics from MIT. I worked for the Federal Reserve Board from 1996 to 2002, regularly briefing Alan Greenspan and working on the FOMC's macroeconomic forecast. From 2002 to 2007, I worked for the Central Bank Ireland and attended many meetings at the European Central Bank.
My research on macroeconomic issues has been published in many of the world's leading economics journals. These days, in addition to my research, I teach classes, supervise PhD students and comment on macroeconomic and banking issues with a particular focus on Europe. I’m also a member of the European Parliament Economic and Monetary Affairs Committee’s expert panel of advisers on monetary policy. You can find out more about me at www.karlwhelan.com and follow me on Twitter at @WhelanKarl.

Ireland's Promissory Note Deal

Ding dong the wicked bank is dead. Anglo Irish Bank is no more. Its successor, the Irish Bank Resolution Corporation is being liquidated. Unfortunately, its legacy of debt piled on the Irish public’s shoulders is not dead. Still, last Thursday’s announcement, which saw the infamous promissory notes replaced with a series of very long-term bonds, is a useful step in reducing the burden associated with the IBRC. Credit is due, in particular, to the Central Bank of Ireland Governor, Patrick Honohan, who oversaw new arrangements being put in place that secured the approval of the ECB Governing Council.

(Photo credit: infomatique

In this post, I discuss the new arrangement and put some numbers on its benefits. I also discuss some of the objections to the deal that have been raised in Ireland and conclude with a discussion of some of the legal issues considered by the ECB when approving the deal.

Some History

IBRC was created from merging two institutions that had borrowed extraordinary amounts of money under an Extraordinary Liquidity Assistance (ELA) program from the Central Bank of Ireland to pay off creditors. This money was created with the approval of the Governing Council of the ECB. The Irish government provided guarantees to the Central Bank of Ireland that these loans to the state-owned IBRC would be repaid. The repayments would see the money created by the original loans taken out of existence.

To allow the IBRC to repay its loans (and to provide collateral for those loans) the Irish government agreed in 2010 to provide it with so-called “promissory notes”. These notes provided the bank with payments of €3.1 billion per year over the next decade from the Irish government, approximately 2 percent of Irish GDP each year. In calculations I reported here before, I estimated that IBRC would have paid off its debts to the Central Bank by 2022. While the promissory notes had additional payments scheduled for years after 2022, these payments could have been cancelled and the bank liquidated.

Instead, the IBRC was liquidated last week. However, rather than the Central Bank of Ireland taking possession of the promissory notes, an agreement was reached to rip up the promissory notes and instead provide the Central Bank with €25 billion in new very long-dated bonds.

The New Bonds

As described here, the new bonds have maturities ranging from 27 years to 40 years with a weighted-average maturity of 34.5. So this means no repayment of principal on these bonds for 27 years. The bonds carry a variable interest rate that tracks six-month Euribor rates with an average additional margin of 263 basis points.

The impact of these interest payments on the cost of the transaction will change over time. At first, the bonds will belong to the Central Bank of Ireland. However, the Central Bank hands back its surplus income to the Irish Exchequer, so these interest payments can be considered a circular transaction in which interest is handed over to the Central Bank to eventually be handed back to the Irish government.

Crucially, however, the Central Bank of Ireland has agreed to dispose of the bonds over time by selling them to the private sector. This will gradually increase the amount of interest that is being paid out and not simply returned by the Central Bank. A presentation from the Department of Finance states:

The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.)

If this minimum amount of sales is stuck to then it will take until 2032 for all the bonds to be in private hands. On Irish television on Sunday, however, Patrick Honohan said the bonds would be sold “as soon as possible” but also said he didn’t see pressure from the ECB being applied to force a quicker pace of sales than the minimum agreed last week.

The fact that the bonds need to be sold to the private sector (and at an uncertain pace) means that claims that the deal “pushes the cost out over 40 years at low interest rates” are not entirely correct.

If the Irish government was able to borrow large amounts of money now over 40 years at Euribor plus 263 basis points then they would have done so and used the money to retire the promissory notes and liquidate IBRC. At present, we can have no guarantee that the sales of these bonds will occur at par value. If private investors in the future are only willing to purchase these bonds at higher yields than the Euribor-plus-263bp coupons, then the Irish government (in the form of its Central Bank) will incur a loss on these sales. So while it turns out the new arrangements place a far lower burden on Irish taxpayers over the next few years, they don’t “kick the can” of refinancing the IBRC debt quite as far down the road as many have been assuming.

Some Calculations

Here is a spreadsheet that I’ve put together that allows for a comparison of the new arrangements involving €25 billion in new bonds with how this €25 billion would have been paid off under the previous promissory note structure. The calculations of the annual cost of the promissory notes are along the lines of those reported in my post from last November.

Importantly, the spreadsheet assumes that bond sales correspond to the minimum described above, so the estimated benefits will be lower if the bond sales are faster. It also assumes that the sales of private bonds will occur at par value and won’t add to the estimated costs. Future Euribor rates up to 2024 are estimated by deriving forward rates from the mid-swaps interest rates reported in Friday’s Financial Times and then held constant for subsequent years.

A summary of the calculations:

The promissory notes would have paid off the €25 billion in 10 years, meaning an average net cost of €2.5 billion over the next decade. This is lower than the annual €3.1 payment because some of the payments would have taken the form of interest payments to the Central Bank which could have been returned to the government.

In stark contrast, the total net payments under the new arrangements over the first decade are only €1.4 billion. While I project €11.2 billion in total interest payments through 2022, all but this €1.4 billion go to the Central Bank. In this sense, the new arrangements provide a very substantial relief over the next decade relative to the previous ones.

Slightly less positive is the fact that €6.5 billion in long-term bonds must be sold up to 2022. From the point of view of financial markets, these sales will be treated in pretty much the same way as new bond sales. They represent the Irish public sector incurring a new debt to the private sector. So the new arrangement leads to financing demands of €7.9 billion over the next decade (€1.4 billion to pay the interest and €6.5 billion in bond sales) relative to €25 billion required under the promissory notes.

After 2022, the new arrangements become more demanding. The decade 2023-2032 sees €9.6 billion in interest payments to the private sector and €18.5 billion in bond sales. The decade 2033-2042 sees €13.8 billion in interest payments and €4 billion in principal payments. Finally, 2043-2053 sees interest payments of €7.36 and €21 billion in principal payments.

There are a number of ways to think about the benefits of the new arrangements.

With the public debt ratio now over 122 percent and investors potentially concerned about the prospects of sovereign debt restructuring taking place if the debt ratio cannot be stabilized, the dramatic reduction in financing requirements over the next decade is helpful. It reduces the chances of a sovereign default triggered by inability to meet payment demands to the private sector.

More generally, delaying payments off into the future allows them to be dealt with at a time when inflation and economic growth have reduced the burden they impose. For example, the final two principal payments of a combined €10 billion will occur in 2051 and 2053. If made today, these payments would account for 6.25 percent of Irish GDP. However, if nominal GDP grows at 4 percent per annum over the next 40 years, these payments would be closer to 1 percent of the GDP at the time of the payment, making it far easier to simply roll this debt over.

One way to calculate the reduced burden due to delaying payments is to calculate the net present value (NPV) of the stream of payments. The spreadsheet uses a 6 percent per annum discount rate and calculates the NPV of the promissory note payments as 19.5 billion and the NPV of payments under the new bonds as €12.8 billion. This represents a 34.4 percent reduction in the NPV. While clearly some way short of a full write-off, last week’s deal still represents a clear improvement on the promissory notes.

Objections to the Deal

Some of the reaction to the deal in Ireland has been negative. Some have criticized the new arrangements because they don’t involve a full write-off of the IBRC’s debt. However, the European Treaty’s outlawing of “monetary financing” makes it clear that loans from central banks to state-owned banks can’t simply be written off and there was never any chance whatsoever that such a write-off could have emerged from negotiations with the ECB. Those with moral objections to the nature of this debt should consider whether the Irish authorities should have rejected a deal that reduced the burden of the debt because of the absence of an unattainable deal.

A second objection has been the idea that the deal simply “kicks the can down the road” or (more emotionally) “forces our children and grandchildren to pay off huge debts”. Well public debt rarely ever gets paid off. Instead it is rolled over as long as financial markets believe governments have the capacity to honor their debts. Unless economic growth and inflation come to an end (in which case the Irish people will have a lot more than IBRC debt to worry about) future generations of Irish taxpayers should be able to roll over these debts (Though before Ireland’s children all grow up and have children of their own, the country will face the challenge of selling large quantities of the new bonds next decade without generating losses).

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There are a few areas of the IBRC liquidation and transaction that remain unclear to me however I just want to focus on one and was wondering if you had any thoughts on the matter or if there is something I am missing.

As you know and have written on extensively, the ELA debt for IBRC was administered in 3 contractual arrangements between IBRC and Central Bank of Ireland, the Master Loan Repurchase Agreement (MLRA), Special Master Loan Repurchase Agreement (SMRA) and the Facility Deed (FD).

According to the IBRC June 2012 interim reports borrowings from the Central Bank of Ireland under special funding facilities at 30 June 2012 amounted to €41.7bn. The total amount of loan assets assigned as collateral under the MLRA facility with the Central Bank of Ireland was €5.9bn. The promissory notes were pledged as collateral for funding under the SMRA with the Central Bank of Ireland and at June 2012, the combined principal amount of the promissory notes was €27.1bn.

All of the other ELA debt was contracted under the Facility Deed which according to the Anglo Irish Bank Annual Report 2010 is an unsecured loan facility guaranteed by the Minister for Finance who separately benefits from a counter indemnity from the Bank should the guarantee be called upon.

So the ELA debt figures and the promissory note figures appear to have changed since June 2012, based on the Department of Finance documentation but working off the June 2012 figures, assuming no discount for the promissory notes and no discount for the €5.9 billion of assets assigned as collateral under the MLRA facility, the total nominal amount of ELA debt covered by the Facility Deed in June 2012 should have been €8.7 billion. Of course there most likely is some discount applied for the €5.9 billion of assets assigned as collateral under the MLRA facility but we don’t know what that is.

One clue can be found from a Simon Carswell article written in August of 2012 where he refers to 2011 accounts for the former Anglo subsidiary, IBRC Mortgage Bank (IBRCMB), saying it moved a further €3 billion of commercial property loans into the “cover assets pool” to be used as collateral to raise €1.5 billion of fresh funding during the year.

In the June 2012 IBRC interim reports, it states that the increase in loan assets assigned as collateral under the MLRA facility with the Central Bank of Ireland was due to the inclusion of loan assets previously assigned to IBRCMB which was at €2.6 billion in 2011. Therefore a €3.3 billon increase is likely to be attributed to these commercial property loans which were sought to raise €1.5 billion of funding in the open markets, ergo up to a 50% discount of ELA debt funding was likely to have been applied by the Central Bank of Ireland on a least €3.3 billion of the €5.9 billion of assets assigned as collateral under the MLRA facility.

According to the official documentation published by the Department of Finance, it is only the Exceptional Liquidity Assistance (ELA) Facility Deed that is being acquired with mention of the MLRA facility.

“NAMA, through an SPV, has been directed to acquire the Exceptional Liquidity Assistance (ELA) Facility Deed and the associated floating charge over the other IBRC assets from the CBI.”

The document further states that after acquisition of the ELA Facility Deed, NAMA will enforce its security entitling it to the proceeds of the sale of the charged assets.

In theory, the liquidation of IBRC and enforcement of its security by NAMA should mean that the Ministerial guarantee and counter indemnity from IBRC to honour this guarantee are in place and the enforcement of NAMA on its security in the acquisition of the Facility Deed ELA means the indemnity on the IBRC assets to honour the ministerial guarantee comes into play.

Equally however the liquidation of IBRC should have meant that the IBRC no longer retains ownership of the €5.9 billion of assets assigned as collateral under the MLRA facility with the Central Bank of Ireland.

Therefore there should only be a minimum of €8.7 billion and depending on discounts up to €10 billion of NAMA bonds issued to acquire the ELA facility deed.

If the disposal of the €5.9 billion of assigned collateral under the MLRA facility with the Central Bank of Ireland does not redeem the full value of ELA debt provided over those assets, the Minister for Finance would have to satisfy the Central Bank of Ireland with whatever extra is required because of the letter of comfort.

However I don’t see how the repayment to the Central Bank of Ireland on assets it now owns has relevance to the counter indemnity from IBRC to honour the Ministerial guarantee relating to the facility deed for the MLRA facility.

The other option would be for NAMA to also acquire the Exceptional Liquidity Assistance (ELA) MLRA and the pledged collateral from the Central Bank of Ireland but this has not yet been announced or stated in any of the documentation.

As of now though, and in accordance with the June 2012 IBRC interim reports, the Central Bank of Ireland should own €5.9 billion of assets and should therefore be responsible for their disposal. This disposal process should in theory have no correlation with the Special Liquidator valuation and disposal process or indeed the Department of Finance. In effect this would mean another loan sale competitor to NAMA and the IBRC special liquidator.

Karl piece seems to be confined to the logic of the market, and as such leaves out lots of areas of public debate around the issue

The first is that many people feel that the Irish gov have no political legitmacy is making these decisions around the Prom Notes in the first place. Michael Noona himself has described the Prom Notes as illegal

see here https://www.youtube.com/watch?v=2x59Ksq0A6o

Taken this as a given, it seems remarkable that an economist will argue that this current deal is legitimate when clearly there has been no democractic mandate from the population itself.

The Gov forced through legislation in the middle of the night, with many of the TDs from the constituent gov parties clearly drunk (the parliament bar remained open all day until 2am) and refusing to allow a proper debate on the IBRC Act that liquidated the banks.

It would be nice if Forbes presented some other perspectives from Ireland about this deal. Unfortunately like much of the west, the perspectives of tenured academic economists seem to be far too much weight when other socio realities exist out there that are seeking a more just and democractic solutions to the current crisis. Technocratic strokes will not fix this no matter how its dressed up.

“AN official of the former Anglo Irish Bank must swear a “yes or no answer” as to whether the bank was solvent in 2009 when it allegedly gave €88m in loans to a developer, a judge said today.

A solicitor for developer Kevin McNulty had sought court orders requiring that all documents be disclosed, or “discovered”, relating to Anglo’s solvency after September 2008 as part of his client’s defence to proceedings brought against him by a NAMA company which took over the Anglo loans.

One of the “fundamental defences” being advanced by Mr McNulty and his companies was that Anglo, which was nationalised in January 2009, was insolvent when it purported to make the alleged loans, solicitor John Larney said in an affidavit to the Commercial Court.

While there was “a wealth of evidence in the public arena” suggesting the bank was insolvent since 2008, such material woud not constitute the proof required by a court and that was why discovery was being sought, Mr Larney said.”

Meanwhile….

“Denis O’Brien, the telecoms entrepreneur, is listed as owing Anglo Irish Bank €833.8m on foot of personal and corporate loans just after the bank was nationalised in 2009, making him its then sixth largest borrower.

Denis O’Brien is the largest single shareholder in Independent News & Media, the publisher of the Sunday Independent. He has lost an estimated €500m on his 21.6 per cent stake in the media group.”

That €500m loss is the amount O’Brien borrowed from Anglo for the shares – is he going to pay back a loan for an asset he no longer has? If and when the loans are transferred to NAMA, there is a strong possibility that they will be rendered null and void. Of course, before that there is a chance that the loan will be sold on, probably at a very significant discount. Loans transferred to NAMA from AIB and Anglo had up to a 70% haircut. But with a ‘quick sale’ on the back of this rushed liquidation if someone is willing to offer to buy them at a 90% discount then the liquidator would sell them. All that someone in Denis O’Brien’s position has to do is ask someone else to offer to buy the loan for him. The Anglo loans that Denis O’Brien has includes the one that funded the €45m acquisition of Siteserv, the infrastructure and utilities support services business. As the Indo article reports:

“This purchase was controversial as the taxpayer took a €105m hit.”

This is because the sale of Siteserv to O’Brien involved a 70% haircut. With the further restructuring his loans imminent with the transfer its reasonable to assume that ultimately the haircut will be 100%. If, as speculated, Siteserv win the contract to install water metres in Irish homes, and given that the Minister in charge of it is another Anglo customer Phil Hogan who has previous with Denis O’Brien this possibility becomes more likely.

The point here is not about Denis O’Brien the individual businessman. I refer to him because some of the detail of his dealings with Anglo have already come to light. When looking for the reasons behind the rushed legislation to liquidate IBRC and to transfer the promissory notes to a long term sovereign bond we have to investigate how this class operates and what are the real motivations behind its actions.

There is much made of that fact that the promissory note payment was politically difficult. But the promissory note had been in place since 2009 and since then the bank which had breached its banking license was operating as a normal bank despite being insolvent. The loan to Denis O’Brien to purchase Siteserv was given in March of 2012 even though IBRC acknowledged that it had breached its licence in its financial report for the first six months of 2012 (see page 18 of the report).

The wind down plan for IBRC had a target date of 2020, which Alan Dukes in November of 2012 felt could be easily achieved. Indeed he argued it happen sooner if it was possible to reduce the interest rate on the promissory notes – an option that in the end was not even sought.

However, winding down more quickly was seen as being the more expensive option, for obvious reasons:

“Mike Aynsley, chief executive of IBRC, told the Oireachtas Committee on Finance, Public Expenditure and Reform that the bank could run itself down more quickly but that could increase the cost. Mr Aynsley said the bank’s net loan book of €15 billion – after taking almost €11 billion to cover bad debts – could more than halve by 2015 and the nationalised bank hoped to have exited the UK market fully by the end of 2014.”

The speed of the legislation, its unusual powers which are now subject to constitutional challenge and the fact that controversial loans will be hidden in NAMA suggest that the reason for this action was one of self-preservation. The David Hall case, with the decision of the judge to only allow TDs to take it – a decision designed nakedly to delay the action – had the potential to show that the promissory notes were illegal. The decision to move the promissory notes into long term sovereign bonds was always an option available to the government. They could have done it at any point. The ECB had no opinion about this because it didn’t affect them. The rolling over of the ELA occurred every two weeks. The purchase of the notes by the Central Bank of Ireland means that the value of that collateral will be reviewed by the ECB once a year. From the ECB’s point of view, there is almost no difference between them.

When we look at the benefits and the costs of this manoeuvre we have to be honest about who gains the benefits and who has to accept the costs. It simply was not possible to continue to pay the 3.1 bn every year for the promissory note. However, the Irish government would have continued to do it if a challenge had not been brought against the legality of the notes. The fact that the bank was continuing to do business long after it was bankrupt suggests that for some it was considered to be useful as it was. With a court case pending it had, all of a sudden outlived that usefulness.

A legal challenge also had the potential to open up the books at Anglo Irish Bank. Once moved under the cloak of invisibility that is NAMA that danger passed.

This arrangement was not designed to reduce the cost of paying for Anglo Irish Bank and Irish Nationwide, but to protect our local bourgeois from anyone looking too closely at what those banks got up to.

From http://www.irishleftreview.org/2013/02/12/tale-anglo-borrowers-tells-future/